Morningstar View: Why risk is a risky business

Risk-targeted funds are attracting considerable attention in the UK marketplace.

It is not hard to see why this is the case. Investors and those who advise them are sure to find appeal in the apparent certainty of being able to quantify and thereby contain their risk.

Therein lies the problem, as ‘risk’ is a slippery term.

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Investment professionals often take as a measure of risk the volatility of returns as expressed by standard deviation. They might also express it as the risk of gains forgone, or the risk of not meeting a specific investment goal, etc.

Thus, when a fund bills itself as risk-targeted, the first question anyone should ask is: what risk?

In many cases, risk is defined by such funds within absolute volatility bands – the Santander Atlas Portfolio targets 5.5 per cent volatility with lower and upper bands of 4.25 per cent and 6.75 per cent, respectively. This is not an uncommon approach. Another approach might target a percentage of the volatility of a given benchmark, as Rathbones does.

A considerable body of evidence, however, has shown that investors greatly prefer avoiding loss to earning gains.

Put more practically, people have an outsized fear of losing money. Standard deviation of returns, which does not distinguish between upside and downside is, in this light, a less than ideal measure of risk.

This mismatch is exacerbated by the tendency of targets such as these to provide investors with a feeling of precision and control over the risk of loss that could be misleading.

How misleading? It is worth remembering that market volatility trended down for years before the financial crisis of 2008. The three-year annualised standard deviation of the MSCI World index in dollar terms was just 7.65 per cent at July 31 2007 – this was the absolute lowest level of volatility for the index in any rolling monthly three-year period as far back as 1970.

Our data stream on the index starts in January 1970 and encompasses 498 rolling three-year periods between then and the end of May 2014.

Between November 2007 and the end of February 2009, the same index plunged 54 per cent. In other words, just when its volatility was at a nearly 40-year low, the index fell off a cliff.

The lesson is that volatility can be a poor proxy for the risk of loss (this is one of several reasons that we view the SRRI indicator required on Kiids to be generally unfit for purpose).

One might argue that such events are extreme, but investors most need protection when the danger is greatest.

Further, such events are not as rare as one might think: Indeed, an analysis by Laurence Siegel of the CFA Research Institute found no fewer than 11 instances of asset classes losing 49 per cent or more since 1911.

It’s worth keeping firmly in mind that a fund’s risks are ultimately defined by the securities it owns. This cannot be captured in a product-specific risk target and may render that target meaningless in a portfolio context.